Traders and investors await the Fed’s message following this week’s policy meeting

The yield premium investors charged to hold the benchmark 10-year Treasury note relative to the two-year note fell to near a nine-year low ahead of the latest interest-rate decision by the Federal Reserve.

The Fed started its two-day meeting Tuesday and is scheduled to release a statement Wednesday afternoon.

A popular trade to position for tightening policy from the Fed is to sell short-term debt and migrate cash into long-term bonds, shrinking the latter’s yield premium.

Yields on short-term debt are highly sensitive to the Fed’s policy outlook. Besides, investors believe that higher interest rates from the Fed would keep a lid on inflation, a main threat to the value of long-term debt over time.

Some bond investors are bracing for indications from the Federal Reserve that the central bank could raise rates by year-end.
Photo:
Associated Press

In late afternoon Tuesday the yield on the benchmark 10-year note was 1.561%, down from 1.571% on Monday. Yields fall as bond prices rise.

The yield on the two-year note settled at a one-month high of 0.762%, compared with 0.733% on Monday.

Tuesday also saw the release of data showing that purchases of new single-family homes rose 3.5% in June from a month earlier to the strongest monthly sales pace since February 2008.

Interest-rate futures suggest many investors doubt the Fed could raise rates so soon given the uncertainty about global growth. Some investors also believe that the Fed is unlikely to tighten policy ahead of the presidential election in November.

“We expect the Fed to remain in wait-and-see mode,” said John Briggs, head of strategy for Americas at RBS Securities. “I do not think they want to be hawkish because there is a long time until the September meeting.”

Fed-funds futures, a popular tool for investors and traders to place bets on the Fed’s policy outlook, indicated on Tuesday that investors assign a likelihood of 20% to a rate increase by the September meeting, according to CME Group.

The 10-year yield’s premium over the two-year yield was 0.8 percentage point, down from 0.84 percentage point Monday. A lower premium is known as a flattening yield curve. In the past, it was seen by many investors as a warning sign that the growth momentum may be slowing.

But over the past two years, the premium was partly dragged lower by strong demand from investors overseas who have been struggling to get income amid a record amount of negative-yielding government bonds in Japan and Europe. Analysts say this factor has distorted the signals from the bond market regarding the growth and inflation outlook.

As investors gird for the Fed’s latest decision, demand for Treasury debt sales declined. A $34 billion sale of five-year notes Tuesday drew the weakest demand since July 2009. On Monday a $26 billion sale of two-year notes drew the weakest demand since 2008.

U.S. government-bond yields have risen after setting historic lows earlier in July. Demand had surged after last month’s vote in the U.K. to leave the European Union, but has diminished lately as anxiety over the implications of Brexit has eased.

Tony Bedikian, managing director of global markets at Citizens Bank, said it is premature to declare that the 10-year Treasury yield has hit rock bottom. But for the yields to test new lows, “we need to see significant slowdown in the U.S. and globally,” he said.

Data in the U.S. don’t point to the risk of a downturn, Mr. Bedikian added. If that remains the case, Treasury yields are likely to be pushed higher, increasing the chances that the Fed would carry on with normalizing interest-rate policy, he said.

The 10-year yield closed at a record low of 1.366% on July 8. It was 2.273% at the end of 2015.